housing crisis

President Obama will present a plan for reforming the housing market in a speech Tuesday in Phoenix, Arizona. The inner workings of housing finance are complicated, and how the market is reformed will be crucial to the country’s economic future. In particular, the future of so-called “government-sponsored entities” (GSEs) has serious implications for housing policy, availability, and affordability.

Here’s what you need to know about the GSEs and the president’s proposals for their future as outlined in the speech and a White House’s fact sheet:

What are GSEs, what do they do, and why does the president want to change them? There are two layers to the mortgage market. In the “primary market,” banks and other institutions loan money to people to buy houses. To free up money to make more loans, these originators sell mortgages into the “secondary market,” where they can be packaged and traded by other firms through securities — hence the term “residential mortgage-backed securities,” or RMBS. “Fannie Mae” – the Federal National Mortgage Association, FNMA – and “Freddie Mac” – the Federal Home Loan Mortgage Corporation, FHLMC – were created by the federal government to develop that secondary market for home loans. The two government-sponsored enterprises buy mortgages and insure mortgage-backed securities from the originating lenders so that those lenders have capital to make more loans, thereby increasing access to homeownership.

For decades, the two were private companies, with all market participants understanding they were implicitly backed by federal tax revenues and thus would never be allowed to fail. In 2008, the government took the two companies over, making that implicit guarantee explicit. The takeover meant taxpayers were on the hook for billions of dollars in bad loans. It’s the large taxpayer liability that’s inspired lawmakers to work towards a consensus on how to change or replace Fannie and Freddie in ways that will provide a stable, secure secondary mortgage market that keeps homeownership affordable.

Did Fannie Mae and Freddie Mac cause the financial crisis? In a word, no. The housing bubble that precipitated the financial crisis was inflated by private companies at various levels of the housing finance market. Unscrupulous lenders issued large mortgages with predatory features like adjustable rates that would skyrocket shortly after the ink dried on the paperwork, then sold those loans to financial firms that packaged them up, got them rated as safe investments by ratings agencies, and re-sold them to other firms. After years of escalating subprime lending by private companies that eroded Fannie and Freddie’s market share, the companies were lured into a “race to the bottom” that exposed taxpayers to the risks Wall Street had been packaging up and reselling for profit. As Center for American Progress housing expert Janneke Ratcliffe said in her March testimony before the Senate Committee on Banking, Housing and Urban Affairs, “The housing bubble was driven by the development of a ‘shadow banking system’ in which mortgage lending and securitization was largely unregulated and certainly undisciplined.” The Financial Crisis Inquiry Commission examined conservatives’ claims that the GSEs were responsible for the housing bubble and found them statistically unsound. Despite efforts by Republican members of the commission to ban words like “shadow banking,” “Wall Street,” and “deregulation” from the FCIC report on the crisis, the commission rightly concluded the crisis was caused by Wall Street malfeasance and years of deregulation that prevented government agencies from correcting the industry’s abuses.

If the GSEs didn’t cause the crisis, why is the president talking about changing the government’s role in the mortgage market? The way that the secondary mortgage market does business shapes how the primary mortgage market works. The question of who can get a home loan from a bank depends in large part on who the bank can sell that loan to in turn, which is heavily influenced by how the government participates in the secondary market. The idea is to avoid future taxpayer bailouts of the whole housing finance system without turning homeownership into something only the wealthiest can achieve by completely removing the government from the equation.

What changes is the president proposing to the government’s mortgage market activities? Part of his proposal is to replace the implicit government guarantee of mortgages that Fannie and Freddie provided to Wall Street with an explicit and more limited sort of guarantee. President Obama will propose ending Fannie and Freddie completely and instituting a new, more limited, and clearly stated government role in guaranteeing housing finance. Under this proposal, taxpayer dollars would be the last-resort source of funding to cover losses, stepping in only after all available private-sector funds have been absorbed.

Isn’t it pretty radical to end Fannie and Freddie completely? The president’s proposal reflects a bipartisan consensus that the GSEs should be wound down and replaced with a smaller and explicit form of government backing. The Bipartisan Policy Center has proposed the same sort of unraveling of Fannie and Freddie and an increased role for private companies in bearing credit risks in the mortgage market. So has the Center for American Progress. And Sens. Bob Corker (R-TN) and Mark Warner (D-VA) have proposed legislation along the same lines. The details of how the transition would work are crucial to the success or failure of the move, but there is broad support for the mortgage market reform architecture the president will call for in Phoenix.

If the private sector is going to take over primary responsibility for the mortgage market, won’t that make it harder to get a house? Unwinding Fannie and Freddie is only half of the story. If the private market won’t insure the traditional sort of home loan to a broad swathe of Americans, homeownership and the economic security it’s historically brought could slip out of reach for much of the country. To avoid that pitfall, reform has to include incentives for the private market to continue to make housing affordable and accessible. CAP has called on Corker and Warner to make some changes to their bill that would “provide flexibility for the system to serve low-wealth borrowers,” who pilot programs have shown to be reliable investments when loan terms are tailored to their ability to repay. The president’s proposal includes a small fee on mortgage securities that would fund loan programs targeted to poorer borrowers and rules for the new, mostly private mortgage financing system to ensure the most traditional loans continue to be made.

How can the government shape private-sector behavior without Fannie and Freddie? One important tool is to have all secondary mortgage market activity run through a common platform. That would prevent firms from evading reforms aimed at guaranteeing access and affordability to home loans by creating a regulatory checkpoint for industry standards. Another is to strengthen the Federal Housing Administration, which helps provide reasonable loans to first-time homebuyers and communities that the private market fails to serve. A third piece of the president’s proposal is to get Mel Watt confirmed to head the Federal Housing Finance Agency, which oversees Fannie and Freddie. During his time in Congress, Watt pushed both affordable housing legislation and laws that could have ended the predatory lending that fueled the crisis.